Special Edition-07.pdf - Lahore School of Economics

The Post-Reform Era Maintaining Stability and Growth 69
levels of economic growth both over the short run and the long run and
sustaining solvency. Short term stability is to be interpreted rather broadly
to mean both financial system stability as well as economic stability though
both are intrinsically intertwined. Financial system stability encompasses a
viable, market-based interest rate structure free of volatile movements,
strength and resilience of financial institutions to withstand market swings
and external shocks, and stable financial markets free of asset bubbles and
gyrations in share prices. Economic stability is largely interpreted as price
stability with acceptable levels of inflation, in addition to interest rate and
exchange rate stability. It is difficult to argue which one of these is more
important and peg the sequencing of corrective actions, though clearly it is
difficult to think of economic stability in the face of unstable money and
capital markets, or in the face of widespread distress among financial
institutions, or both.
Generally, stability of the financial system is largely understood as
stability of the banking system only, and seldom does it cross over to concerns
of stability of financial markets. Perhaps one of the reasons is that while
something can be done to maintain stability of the banking system, and to
some extent stability of money and short term debt markets, hardly anything
can be done to ensure that capital markets remain stable beyond creating the
necessary conditions with routine monetary management, if that.
This is true of nearly all countries across the spectrum, not just
developing countries. Monetary authorities find themselves saddled with
their mainline responsibilities, and stay away from encroaching upon the
operations of capital markets, known to be notoriously fickle and having a
mind-set of their own. Further, with all the information flow, their
analytical and predictive capabilities, computing prowess for risk and
returns, sophisticated derivatives and hedge instruments, capital market
participants everywhere find themselves upstaged time and again with large
equity price corrections, exploding bubbles, and massive portfolio value
losses. They have yet to discover ways to simply foresee market trends,
much less devise ways to ensure stability.
The comparative experience demonstrates that in the post-reform
era, among newly opened and liberalized financial systems with enhanced
exposure to market-based forces, both domestic and foreign, sooner or later
both the banking system and financial markets have faced the onset of
instabilities that eventually degenerated into financial crises with a rapidity
and severity that surprised everyone. The history of the past three decades
of the post-reform era among many developing countries that have gone
through reform processes, is replete with banking crises or foreign liquidity